Market Segment Specialization Program audit guide for shareholder loans.

On April 25, 2001, the IRS released a Market Segment Specialization Program audit guide that contains audit techniques for shareholder loans. The guide explains how to determine whether a shareholder loan is a bona fide debt or a constructive dividend. It also contains examples of how below-market term and demand loans affect corporations and shareholders.

An IRS agent must determine if an advance to the shareholder is bona fide debt. The primary determination hinges on the question of whether, when the loan was made, there was a genuine intent that the funds would be repaid. The guide states that in answering this question, the courts have not looked to mere labels or to the parties' own testimony, but to the transaction's facts and circumstances. Over the years, a set of common-law factors for determining bona fide debt has emerged. The determination is not an exact science and no single factor is determinative.

The key factors in determining if a debt is bona fide are:

1. The extent to which the shareholder controls the corporation;

2. Whether security is given for the advance;

3. The shareholder's ability to repay the advance;

4. The corporation's current or accumulated earnings and profits;

5. Presence of a repayment schedule or an attempt to repay the advance;

6. Set maturity date to the "debt";

7. Interest (if any) charged on the advance;

8. The corporation's ability to force repayment if the shareholder fails to make the required payments;

9. The magnitude of the advances;

10. Existence of a ceiling limiting the amount the corporation advanced; and

11. The corporation's dividend history. According to the guide,

[I]t cannot be emphasized enough that the ... factors must be viewed as a whole. Any factor considered on its own will probably not be determinative. The purpose for analyzing the above-stated factors is to determine the parties' intent at the time of the distribution. In addition, this list of factors is not all-inclusive. Any facts that may provide insight into the parties' intent at the time of the distribution should be developed.

The guide discusses the following points, which also help an agent in determining whether the debt is bona fide:

* The taxpayer may be held to its reporting position.

* Two related judicial doctrines, equitable estoppel and duty of consistency, are available to prevent a taxpayer from treating an item in a certain manner for one tax year but, after the expiration of the statute of limitations, attempting to treat the item in an inconsistent manner in later years.

* In the case of an S corporation, if the corporation reasonably compensated the shareholder, part of the advance might need to be reclassified as compensation and therefore subject to employment taxes.

The guide concludes with a detailed discussion of below-market loans and the rules under Sec. 7872. It gives extensive examples that show how to compute forgone interest in a below-market demand and term loan.

FROM KIMBERLY A. BUTLER, COCA-COLA ENTERPRISES INC., ATLANTA, GA

Mark H. Ely, J.D., CPA
Partner
Washington National Tax
KPMG LLP
Washington, DC